Avoiding Risk When Investing

Risk is a four letter word to the investor trying to grow their investments. Whether the investment is in the stock market, real estate or some other investment vehicle, the smart investor will do everything they can to minimize their risk through proper risk management. There are tricks and methods to reduce risk for the stock market investor through diversification of their investment.

There are three types of risk. Business risk is where the business fails or fails to meet the investor’s expectations. Market risk is where the stock market as a whole is compromised. Interest risk is more of a global risk due to currency shortfalls. Through risk reduction the savvy investor can make these risks go away as much as possible.

Investing in mutual funds is one method that can be used to reduce risk. A person can invest a fairly small amount of money in a mutual fund and still be invested in a large portion of stocks or other investments. By purchasing shares in several mutual funds, the investment results in a situation where the three types of risk mentioned above are reduced. This is because the investment portfolio is spread over many different stocks. The investment manager for the mutual fund uses the mutual fund mission statement to establish investing strategies. He then determines the stocks he wants to invest in and the percentage of each stock he will hold. A good mutual fund will not have more than 10% of the investment held in one particular stock.

Stock funds are not all the same. They fall into different asset classes. For example, there are funds which invest only in growth funds. Some invest in dividend producing funds. There are also funds which are known as index funds. These index funds invest in the market as a whole. For example, the S&P 500 index fund follows what the S&P 500 is doing. Funds can also invest in specific industries and are known as Sector funds.

Investors can purchase mutual funds from a broker that will purchase from the fund itself or from other brokers. When purchasing mutual funds, the drawback is that the price paid is not really known until the end of the day. The purchasing order is not really processed until the end of the day. This is because mutual funds are not like stocks. With stocks the price for the stock is known instantly. Mutual funds have to calculate their value at the end of the day. Therefore, the purchase order can not be processed until the value is known. This is one of the negatives when investing in mutual funds.

The value of a mutual fund is known as the net asset value (NAV). The calculation of the NAV is really simple. At the end of the day, the current market value of the funds assets are divided by the outstanding shares. This is known as the funds net asset value. The funds assets are actually the liabilities of the fund subtracted from the assets. It is important to keep a watch on the funds NAV since that is in essence what the fund is bought and sold at.

There are three ways to make money with a mutual fund. The first is the dividends paid to the mutual fund via its stock holdings. The second is the capital distributions that are derived when the fund sells shares of the stock it holds. The third is when the NAV changes either up or down.

In order to maximize the risk reduction, the investor should purchase several different types of funds that are not correlated with each other. Correlation is the process where the stocks move together. The degree which these funds move together or do not move together is known as the correlation. For example, if a stock has no correlation with another stock, if that stock goes down, the first stock will probably go up. The determination of correlation uses a regression analysis which in essence plots the returns and risk for each fund on a graph and determines how they move in relation to each other. The math behind the analysis is a little complicated. There are correlation calculators available on the internet that will simplify this math. By plugging in the funds, you can find out how they correlate to each other. It is important when putting together an investment strategy that the investor build his portfolio with as little correlated funds as possible. Stock correlations range between +1.0 and -1.0. If an evaluation of two stock funds shows they have a correlation of.93, when you invest in these two funds, you are in essence investing in just one fund since they tend to move together. A better scenario would be to invest in funds that have a correlation of -.25. This would better diversify your portfolio.

When determining your investment strategy and deciding on which funds to invest in, it is important to do a thorough review of the investment manager and the types of investment the fund makes. Do not let yourself get glamorized by the reported growth of the fund. It is important to know that what goes up can very easily come back down. Just because a fund has a good year does not mean the next year will be good. Take the time to review what industries are growing and how the proposed investment will actually fit in your strategy.

Be wise in your investments. Take the time to do proper research. Do not just rely on a good story. Every manager has a good story. The proof is in the pudding, so to speak. Look at the long term history and make good decisions. After all, it is your money. A long term strategy is also needed. If you are investing in stocks and need your money for a purchase within two years or less, you should not be investing in the stock market.